The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Friday, February 25, 2011

Are Higher Capital Requirements a Substitute for Current Asset-Level Disclosure?

Perhaps the most vocal academic for banks holding more capital is Stanford finance professor Anat Admati. In a Bloomberg column, while laying out a compelling case for why the Too Big to Fail should not be allowed to begin paying dividends yet, she also makes the case for current asset level disclosure.

She does this when she calls for "better ways to monitor the true leverage and risk of financial institutions".

This is an explicit acknowledgement that higher capital requirements, bail-ins, living wills and hybrid securities are not a substitute for current asset level disclosure. As regular readers of this blog know, the only way to actually monitor leverage and risk is to have current asset level disclosure.

People become scared when ex- regulators or bankers warn that growth might be hurt or that the recovery would be slowed if we fail to do something. The Federal Reserve seems scared, too, or maybe captured, since it is about to allow increased dividends from banks.

The Fed should know better. Allowing high payouts to shareholders raises financial institutions’ leverage and that is bad for the economy.

One of those warning that growth will suffer is William Isaac, head of the Federal Deposit Insurance Corp. from 1981 to 1985 and now chairman of Fifth Third Bancorp. Writing in the Financial Times on Feb. 9, he said that unless banks increase dividends they will have a harder time raising equity in the future, thus hurting the economy.

This is similar to the flawed assertions made by bankers who are lobbying against increased capital requirements.

We have seen self-serving statements like this before. ... And the doom and gloom we were promised? There is no evidence ...[of] any negative economic consequences.

Confusing language often obscures the discussion of capital regulation and makes it more difficult to evaluate such threats. .... Capital is simply equity, the value of shareholders’ ownership claims in banks; and it represents a way for banks to fund their investments without undertaking debt commitments that they might not be able to meet and which add to systemic risk.

Bankers are fiercely resisting the suggestion that they use more equity and less debt in funding, even though this would reduce their dangerous degree of leverage.

... when banks are highly leveraged, their equity can be easily wiped out by small declines in asset values. If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption, the need to “deleverage” by liquidating inefficiently, and possible contagion through the interconnected system. As we have seen, this can have severe consequences for the economy.

...Isaac is right to point out that the structure of current capital requirements distorts banks’ decisions. The structure, which is focused on the ratio of equity to so-called risk- weighted assets, might induce banks to choose investments in securities over lending, because securities with high credit ratings require less capital and thus allow more debt funding.

These failures of the system of risk weights, however, have nothing to do with the overall level of capital. Allowing banks to pay dividends and maintain high leverage isn’t the solution to this problem. Instead, better ways to monitor the true leverage and risk of financial institutions should be found.

Isaac says he favors high capital requirements, but he says that paying dividends now is important for banks’ ability to raise equity later. As prominent academics explained in a letter responding to his column, his arguments for allowing dividends are weak.

The muddled debate on capital regulation has left us with only minor tweaks to flawed regulations, even after banks’ catastrophic failure in the crisis and the lasting consequences for the economy. The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas.

Until they build up much greater capital, banks should retain their earnings rather than make payouts to equity. Bank boards, helped by regulators, should make sure that “excess capital” isn’t wasted or cause banks -- as JPMorgan Chief Executive Officer Jamie Dimon said -- to do “stupid things.” And empty, self-interested threats shouldn’t win another round of implicit subsidies if we are to prevent another crisis.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.